I am writing today to help inform people who are new to the stock market and want a simplistic look at the return on FSD Pharma Inc (CNSX:HUGE) stock.
FSD Pharma Inc (CNSX:HUGE) delivered a less impressive 2.11% ROE over the past year, compared to the 5.30% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into HUGE’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of HUGE’s returns. View out our latest analysis for FSD Pharma
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests CA$1 in the form of equity, it will generate CA$0.021 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Pharmaceuticals sector by investing in the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt FSD Pharma has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of FSD Pharma’s equity capital deployed. Its cost of equity is 17.66%. This means FSD Pharma’s returns actually do not cover its own cost of equity, with a discrepancy of -15.55%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue FSD Pharma can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at FSD Pharma’s debt-to-equity ratio to examine sustainability of its returns. Currently, FSD Pharma has no debt which means its returns are driven purely by equity capital. This could explain why FSD Pharma’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. FSD Pharma exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of FSD Pharma’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For FSD Pharma, I’ve compiled three important aspects you should further examine:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does FSD Pharma’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of FSD Pharma? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!